IMF Concludes 2003 Article IV Consultation with Iceland

Rapid growth during the second half of the 1990s led to overheating and the emergence of financial vulnerabilities by the end of the decade. Over the medium term, investment projects will impart a significant impetus to economic activity, and output will grow for some years above its long-term trend pace. There are, however, significant upside risks to this medium-term central scenario. Executive Directors supported the authorities' view that macroeconomic policies would have to remain restrictive to counteract the expected demand pressures over the medium term.


Rapid growth during the second half of the 1990s led to overheating and the emergence of financial vulnerabilities by the end of the decade. Over the medium term, investment projects will impart a significant impetus to economic activity, and output will grow for some years above its long-term trend pace. There are, however, significant upside risks to this medium-term central scenario. Executive Directors supported the authorities' view that macroeconomic policies would have to remain restrictive to counteract the expected demand pressures over the medium term.

On August 22, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Iceland.1


Economic developments since early 2001 have resulted in the correction of the external and domestic macroeconomic imbalances that emerged during the boom of the late 1990s. The 2001 depreciation of the króna sparked a redirection of activity towards the external sector. Domestic demand, which had grown well in excess of GDP, contracted in 2001–2002 at an annual average of 3 percent, while net exports soared. Booming export revenue and faltering import demand brought the external current account into broad balance in 2002, compared to a 10 percent of GDP deficit in 2000. This, in turn, contributed to the rebound of the króna, which appreciated since 2002, aided by high real interest rates and a recovery in confidence. Output grew 2.9 percent in 2001, supported by buoyant exports, and declined ½ percent in 2002, opening some slack on the labor market. High frequency indicators suggest that activity has started to edge up in 2003. In early 2003, agreements were reached with foreign investors to undertake large projects in smelting and associated power generation, covering the 2003–10 period and with a total value equivalent to 35 percent of 2003 GDP.

After an initial surge reflecting depreciation pass-through effects, inflation declined rapidly in 2002, responding to the effects of high real interest rates, weak domestic demand, and the recovery of the exchange rate. The 12-month inflation rate, at 1.6 percent in July 2003, has been slightly below the Central Bank of Iceland’s (CBI) inflation target of 2½ percent since November 2002. Credit and M4 liquidity growth has also moderated to low levels. Since early 2002, the CBI has reduced gradually its policy rate by 480 basis points to 5.3 percent in April 2003, and the policy stance is broadly neutral at this juncture. Although domestic demand has started to pick up, labor market slack and the króna’s appreciation have dampened inflationary pressures. The CBI projects that inflation will remain slightly below its target through the fourth quarter of 2004.

The public finances are in broad balance, and the debt burden is low, although expenditures increased significantly in recent years. The overall budget balance declined by about 2 ½ percent of GDP since 1999, to an expected broad balance in 2003. It is estimated that about half of this deterioration resulted from automatic stabilizers, while the remainder reflected sizable expenditure hikes in health, education, and social affairs, due, in part, to wage increases. Owing to buoyant revenue performance, however, the fiscal stance was slightly contractionary in 2002. The general government debt ratio has declined substantially in past years, as fiscal surpluses and privatization proceeds were devoted to debt redemption. Net government debt represented 25 percent of GDP in 2002.

The 2003 Financial System Stability Assessment (FSSA) update concluded that financial sector imbalances identified in the initial 2001 FSSA have subsided. Icelandic banks recorded increased profits in 2001–02, and boosted their regulatory capital ratios, aided by a proactive supervision. A package of financial legislation was adopted that strengthened the powers of the supervisory authority, and implemented regulatory reforms recommended in the 2001 FSSA. As a result of these efforts, Iceland became compliant with ail but one of the Basle Core Principles (BCP).

Iceland’s external debt has grown rapidly in recent years and is high in relation to comparable economies. This is largely the result of economic fundamentals, including a relatively young population, rising household assets (including fully-funded pension assets), and improved access to foreign capital markets. Banks’ liquidity and foreign open positions are strictly regulated and adeptly monitored.

The government has continued pursuing its privatization agenda, most recently with the sale of remaining state-held shares in two commercial banks. Progress in reducing agricultural protection, which remains among the highest in the Organization for Economic Cooperation of Development, and in liberalizing the energy sector is less advanced.

Executive Board Assessment

Directors commended the authorities for rapidly overcoming macroeconomic imbalances and financial vulnerabilities that had developed at the end of the 1990s, through the sustained implementation of stability-oriented policies—including the introduction of inflation targeting, central bank independence, a floating exchange rate regime, and a substantial strengthening of the financial supervisory framework. They noted that the resilience shown by the Icelandic economy during the recent recession was also due to the underlying flexibility afforded by a decade of structural reforms aimed at enhancing long-term economic performance through improved competitiveness and more diversified exports.

Directors agreed that there were good prospects for a resumption of growth in the near term, accelerating over the medium term as the large planned foreign investments in aluminum smelting and associated power-generating facilities gather pace. They warned, however, that while these investments will ultimately expand the export base and thus buttress economic stability, they will also generate a significant demand impetus during the construction phase that will strain resources and increase upside risks, thus complicating macroeconomic management.

Against this background, Directors agreed that the main policy challenge for the period ahead will be forestalling a re-emergence of overheating and containing external imbalances given the already high private external debt level. In this regard, Directors supported the authorities’ view that macroeconomic policies would have to remain restrictive to counteract the expected demand pressures over the medium term. In particular, they agreed that fiscal policy would need to bear most of the burden of adjustment, leaving room for monetary policy to respond to unexpected shocks while avoiding an extended period of high interest rates and possible real over-appreciation of the króna. Directors stressed the need for appropriately tight policies to contain the external current account deficit at a level commensurate to direct project-related imports and compatible with a gradual decline in Iceland’s net external liabilities as a share of GDP.

While noting that the public finances remain fundamentally sound, Directors welcomed the authorities’ intention to build up significant budget surpluses to counteract the envisaged demand push, and urged that this be reflected in the 2004 budget proposal. This would require an early focus on restraining current spending, particularly the public wage bill, an area where repeated slippages have occurred in recent years. Directors also recommended increasing the scope for private sector participation and the use of means-tested fees and co-payments in the provision of public services. Moreover, Directors generally cautioned that the announced tax reductions should be introduced cautiously, and only when countervailing expenditure cuts have been identified.

Directors welcomed the authorities’ decision to cast the 2004 budget in a transparent multi-year policy framework, which would facilitate efforts at fiscal consolidation. Directors thought that firm expenditure limits would contribute to the predictability and credibility of budgetary policies and reinforce market confidence. Directors also noted that the planned adoption of national accounts methodology for budgeting purposes would further enhance fiscal transparency.

Directors considered the current Central Bank of Iceland’s (CBI) broadly neutral monetary stance to be appropriate. They concurred with the authorities that this stance would have to be tightened as the recovery strengthened, remaining moderately restrictive over the investment projects’ implementation period. Directors cautioned against a destabilizing expansion of credit by the Housing Financing Fund (HFF) that could be prompted by the relaxation of its lending criteria.

Directors commended the authorities for their success in implementing the inflation-targeting monetary policy framework introduced in 2001, as evidenced by the swift decline in inflation to the CBI’s target. They also noted that recent reforms had improved the operation and safety of the payments systems infrastructure, and that the ongoing net foreign reserve accumulation would enhance confidence and policy flexibility. Some Directors suggested that, to further promote monetary policy transparency, consideration be given to holding regular rate-setting meetings of the CBI Board of Governors and publishing their minutes.

Directors welcomed the positive conclusions of the Financial Sector Stability Assessment update, reflecting the authorities’ forceful efforts in addressing financial system vulnerabilities identified in the 2001 FSSA. They noted that the banking sector had increased its profitability and capital base, returning to a more balanced risk profile. Directors commended the authorities for the strengthening of the legal and supervisory prudential framework, including the increased powers and resources granted to the Financial Supervisory Authority, as well as the major improvements in compliance with Basel Core Principles of Effective Banking Supervision. Directors nevertheless advised that continued vigilance would be required in the upcoming period of possible macroeconomic tension. They recommended applying explicit prudential rules to the HFF, and carefully monitoring the weaker savings banks.

Directors expressed concern that private sector external liabilities, including short-term maturities, had risen to high levels in recent years while the net international investment position was in deficit, but noted that this might in part be rooted in demographic factors as well as in the buildup of private assets, including through fully-funded pension schemes. Directors considered that banks’ foreign exchange open positions, and liquid assets and liabilities were well regulated and carefully monitored, while a significant part of the exchange rate risk was borne by naturally hedged borrowers. Nevertheless, Directors cautioned that the level of external liabilities, while not a cause of immediate systemic concern, posed medium-term vulnerabilities and reduced the room for policy slippages. They supported, in this connection, the authorities’ objective of raising domestic saving, including through fiscal consolidation, and urged them to carefully monitor the debt levels of households and non-financial corporate borrowers.

Directors commended the authorities’ continued progress in privatization, as evidenced by the recent divestment of the remaining public stake in the banking sector, and encouraged them to privatize telecommunications as early as feasible. They also encouraged them to press forward with liberalization of the electricity sector, and of agricultural trade, where distortions and welfare losses remained large.

Directors welcomed the duty-free access accorded to imports from least developed countries and encouraged the authorities to increase official development assistance toward the U.N. target of 0.7 percent of GNP. They also supported the authorities’ efforts at combating money laundering, the financing of terrorism, and other financial crime.

Iceland publishes statistical data on a sufficiently timely and comprehensive basis to permit effective surveillance.

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF’s assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The Staff Report for the 2003 Article IV Consultation with Iceland is also available.

Iceland: Selected Economic Indicators

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Sources: Statistics Iceland; Central Bank of Iceland; Ministry of Finance; and IMF staff estimates.


National accounts basis.

In months of imports of goods and services

Trade weighted index of the exchange rate as krónur per unit of foreign currency (12/31/1991=100).


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities.

Iceland: Staff Report for the 2003 Article IV Consultation
Author: International Monetary Fund